Profiting from the Fed's Disastrous Mistake

Although there is much fear and uncertainty about the economy and financial
markets right now, there is actually a very clear and simple way to interpret
the current situation, using the monthly charts of equities, bonds, and gold.

In my daily reports I often discuss the 1440 level on the S&P 500 Index
(SPX), as this has been -- and still is -- the clear line of demarcation for
the big pattern in equity markets.

The first two shockwaves from the credit crisis caused two hard tests of
this critical 1440 energy level, back in August and November of last year.
But it was only when the Fed delivered that hapless and disastrous quarter-point
rate cut at the December meeting that the situation escalated into a full-blown
crisis, causing the 1440 level to give way.

It's rare to be able to track a market crisis back so clearly to one particular
event, but all of the ensuing carnage in equity markets that followed in January
2008 was a direct result of the Fed's ridiculous quarter-point cut at the Dec.11
FOMC meeting, where they dropped the target rate from 4.50% to 4.25%.

Only six weeks later, at the end of January, the target rate had been slashed
to 3.00%, on the way to the current 2.00%.

Now that the Fed has been sufficiently slapped around by the markets, the
SPX has been able to scratch and claw its way back up to just under the still-critical
1440 level. Equity markets are once again at the critical balance point, and
are now in position to put this very difficult period in the rear-view mirror.

Bonds have also worked their way back to a similar critical balance point,
at 115.

And gold has moved back to its critical level at $850.

I generally don't advocate putting too much faith in inter-market relationships,
as they have this annoying tendency to break down right when you are relying
on them to hold up.

Yet gold bulls need to be aware of the possibility that a massive rally in
the SPX could wipe out all of the gains in gold since August 2007. Gold will
be in a very precarious position if it sinks below $850.

I'm not actually expecting such a breakdown in gold, at least not in the foreseeable
future, as instead gold looks ready to head back up towards the highs, as part
of its long consolidation pattern that should last well into 2009. There is
definitely a chance that gold can now extend up as high as $975 during the
next leg up in this consolidation, which we'll continue to track on a daily
basis in the Fractal Gold Report.

Getting back to the SPX, there is a very interesting historical analog from
1990/1991 that is worthy of close attention, as this is a great example of
what can happen in a market when "the herd" is gripped by fear, but then suddenly
discovers the fear was overblown.

Back in 1990 there was a straight down move, followed by a grinding reversal
pattern, and then a straight up rally. It's a very similar pattern to what
we're seeing now -- but crucially, we haven't yet seen the straight-up part.

But it's coming.

The key insight from this analog is just how quickly a market can change
its mind in this type of situation. That is, if market participants now sense
that the "greatest financial crisis in 70 years" isn't actually much of a crisis
at all, prices will be re-rated upwards at an astonishing pace.

Back in early 1991, the SPX moved up 20% in only 22 trading days.

A similar move now -- launching from, say, 1385 -- would take the SPX up to
new all-time highs around 1660, in only 4 or 5 weeks.

There is a very good chance that we're only a weeks away from a similar "life-changing" move,
as a 20% upwards re-assessment of equity prices can translate into massive
gains if you're positioned correctly ahead of time in options or other leveraged
instruments. Of course there's no guarantee this launch is going to happen,
but if it does, we're going to be all over this set-up, and playing it for
all it's worth.

Before the SPX is ready for such a launch, there is likely to be one tricky
move down off 1440 to create the right sentiment mix for the rally.

This type of sudden decline is actually an essential part of a developing
uptrend. The SPX needs to convince the majority that it's about to go into
a free-fall, right before it turns around and rallies to new all-time highs.

There are a few specific ways that I'm looking for this pattern to develop,
to know that the "pre-launch" phase is still on track. As always, I'll continue
to update subscribers on
a daily basis on the developing pattern.

Such a blistering move up in equities will also have a dramatic impact on
gold, and it remains to be seen how the gold/equity relationship will behave
during this period. A subscription to the Fractal Gold Report also includes
a subscription to the Fractal Market Report -- a daily update on the S&P
500 index -- and if you opt for the annual
or 2-year subscription plans you will also receive fractal analysis of
silver and platinum.

David Nichols is a graduate of Yale University and a leader
in the emerging field of fractal market analysis. This pioneering analytical
approach studies the markets as chaotic, non-linear systems, addressing the
predictability in financial markets. Fractal market analysis discovers the
order hidden within the seemingly random chaos of the markets.

David is the editor of the Fractal
Market Report and the Fractal
Gold Report, daily subscription newsletters written in an easy-to-understand
style that cover the markets using his proprietary techniques that go beyond
technical and fundamental analysis.